It's been 30 years since "Black Monday," and we're seeing stock market crash warnings that history could be repeating itself...
With the 30th anniversary of the crash of 1987 still fresh on everyone's minds, Money Morning Capital Wave Strategist Shah Gilani told our readers the next crash could be even worse.
Now, Gilani is not predicting a stock market crash. However, we want our readers to be prepared for anything.
And this stock market crash warning sign is sending a signal that smart investors should have a plan...
Why Today Is Looking a Lot Like 1987
On Oct. 19, 1987, the Dow Jones Industrial Average plummeted 22%. That one-day drop, the largest in U.S. history, became known as "Black Monday." Now, three decades later, there is the potential for another huge drop.
Right now, Gilani sees a few parallels to the market conditions that ended with the market crash in 1987. They include a new breed of Wall Street "products" rife with potential unintended consequences. Combining these products with a lack of regulation could be brewing the perfect storm.
The current bull run has seen the Dow gain more than 250% since March 2009. The bull market ahead of the 1987 peak saw only a 160% gain. And leading up to the crash, stock prices outpaced earnings growth in a very similar pattern to what we see today.
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In the 1980s, we saw an influx of investors enter the market, primarily through pension funds and retirement accounts. Today, after years of sitting on the sidelines, individual investors are finally returning to the market with index funds and exchange-traded funds (ETFs).
In 1987, favorable tax treatment for corporate buyouts boosted share prices. Today, the hope for tax cuts, cash repatriation from overseas, and accelerated depreciation scheduling are boosting share prices. The Dow scored 68 record-high closes just since the election.
Commentators back in the late 1980s called the market "overvalued." And they say the same thing today.
"It's clear that conditions are eerily similar," Gilani said.
And with investors flooding the market with index funds, the major Wall Street hedge funds are taking a lot more risk through index arbitrage...
What Could Cause the Next Stock Market Crash
Portfolio insurance and index arbitrage are widely blamed for the speed and depth of the Black Monday sell-off.
In theory, these trading techniques should provide good risk control for traders. However, when stressed to the extremes seen that day, they broke down. They actually caused more risk than they saved.
In today's market, there are infinitely more index products, and index arbitrage is now systemic. And portfolio insurance is packaged in retail products that exist completely outside what investors have in their portfolios and that aren't even connected to the stocks they think they insure.
The products you own, the products hedge funds own, and the products central banks own are all the same. Everyone thinks they are protected, but they are not.
But in 1987, Congress' decision to end a policy that made mergers and acquisitions profitable helped push these index arbitrage strategies to their breaking point. We could see a similar negative catalyst if Congress fails in its bid to make the tax code more beneficial to businesses.
That doesn't mean a market crash in 2018 will happen, but smart investors know the Dow's record-breaking bull run won't last forever. That's why having a plan to protect your money is always a good idea...
Have a Plan to Protect Your Wealth
Smart investors always have a plan to prepare for a stock market crash.
In fact, stock market crashes are devastating because most investors are rarely prepared for a major pullback. You see, the timing of a stock market crash is impossible to predict with any degree of certainty.
But that does not mean investors should flee the stock market. Avoiding the market out of fear is actually one of the biggest mistakes you can make, because the stock market is one of the greatest wealth generators we have.
Instead, there strategies that you can use to keep your money safe.
Here are strategies from four Money Morning gurus to protect your money during a stock market crash - and profit, too...
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How to Prepare for a Stock Market Crash, Step No. 1: Buy Gold
Owning gold is an excellent hedge against uncertainty in the stock market. Money Morning Executive Editor Bill Patalon says gold is a "good 'store of value' when uncertainty gets out of hand."
Gold is considered to be a "safety asset," and it certainly got a bad rap over the past few years. However, considering that the stock market - a "risk asset" - was soaring to all-time highs, it is no wonder.
But when stocks start to fall, gold should gain. Between the start of the financial crisis bear market in May 2008 and its end in March 2009, the Dow lost 49% of its value while gold prices actually rose over 5% in the same time.
We must point out that gold does not pay dividends or interest. Money Morning Chief Investment Strategist Keith Fitz-Gerald says while gold's stability is a real asset to any portfolio, you don't want to overdo it and put all your money in gold. Fitz-Gerald says studies have shown that putting 2% to 5% of your investable assets into gold adds stability to your portfolio without sacrificing growth.
How to Prepare for a Stock Market Crash, Step No. 2: Short the Broader Market
One of the simplest ways to profit during a market downturn is to sell the overall market short. While shorting a stock can expose investors to potentially unlimited losses, our experts' strategy avoids the unnecessary risk so you can profit safely...
You see, a traditional short position requires the trader to sell borrowed stock and buy it back at a later date. If the stock's share price drops, then the trader makes a profit (they sold the borrowed stock at a high price, bought it back at a lower price, and pocketed the difference).
But this strategy can be risky if the stock's share price goes up. In fact, the potential losses could be unlimited if the stock's share price keeps rising.
However, shorting the market doesn't have to be this risky.
Buying funds that short the overall market is a straightforward way to profit from a downturn without being susceptible to infinite risk. These funds go up when the stock market goes down.
Shah Gilani recommends investors buy the ProShares Short Dow30 ETF (NYSE Arca: DOG) if they are confident a downturn is on the way. DOG trades inversely to the Dow Jones Industrial Average, so when the Dow dives, DOG goes up.
Keith Fitz-Gerald recommends a similar strategy, but instead of an ETF, Keith recommends the Rydex Inverse S&P 500 Strategy Fund (FUND: RYURX), a mutual fund that trades inversely to the S&P 500.
Both DOG and RYURX brought their owners 48% and 72% returns, respectively, during the 2008 bear market.
Both of these methods should be employed when market conditions start to deteriorate. They are not "buy now and forget about it" strategies. And investors need to keep a close eye on them. Once the market rebounds, these funds can be sold.
How to Prepare for a Stock Market Crash, Step No. 3: Own In-Demand Stocks
A stock market crash starts when traders panic during "catastrophic events, an economic crisis, or the collapse of a long-term speculative bubble," according to Investopedia.
And a speculative bubble is exactly what led to the dot-com crash of 2000. A bubble also led to the housing crash and financial crisis in 2008.
But investors who didn't chase speculative positions and stuck to companies in the most in-demand sectors were protected from the worst of the crash.
The trick is to find "must-have" companies that fall into what Keith Fitz-Gerald calls the six "Unstoppable Trends": medicine, technology, demographics, scarcity and allocation, energy, and war, terrorism, and ugliness (known collectively as "defense"). Money will flow into these areas through thick and thin.
Two of Keith's favorite Unstoppable Trend stocks are Raytheon Co. (NYSE: RTN) and Becton, Dickinson and Co. (NYSE: BDX). RTN and BDX are leaders in the Unstoppable Trends of defense and demographics, respectively.
How to Prepare for a Stock Market Crash, Step No. 4: Buy Tech at a Discount
Money Morning Technical Trading Specialist D.R. Barton, Jr., says a market downturn is a great time to buy some of the best stocks at a discount. In fact, he thinks it will be a great time to pick of shares of the "Fab Five" tech stocks, which include Facebook Inc. (Nasdaq: FB), Amazon.com Inc. (Nasdaq: AMZN), Microsoft Corp. (Nasdaq: MSFT), Alphabet Inc. (Nasdaq: GOOGL), and Apple Inc. (Nasdaq: AAPL).
It is a simple strategy, but these are the companies that are leading the way into the future. They change the way we live, work, and play. And they could become once-in-a-lifetime do-overs for investors who did not buy them when they were much lower in price.
Even with these strategies, there can be pain during a market crash. However, they will likely help you survive and even put you back on the road to big profits once again.
Never be complacent. Always have an escape plan, and know when it is time to use it.
Editor's Note: "Must-have" companies backed by Unstoppable Trends are a cornerstone of Keith's wealth-building strategy. But there's another type of investment he wants Money Morning Members to know about. It's one of his favorites, a kind of "desert island fund" he'd buy if he had to park his money in one place, "retire" from civilization for 20 years, and come back to a pile of money. Click here to learn more...